Gold Stocks Shine in 2015

Gold stocks have suffered a miserable few years, becoming a laughingstock
even among contrarians. But this despised sector's seemingly-endless downward
spiral has left gold stocks vastly undervalued relative to gold, which drives
their profits. The fundamentally-absurd disconnect between gold-stock price
levels and gold can't last. And it sure looks ready to end, making 2015 the
year gold stocks shine again.

Any stock is a fractional ownership stake in a corporation, entitling shareholders
to participate in that company's profits. So over time, any stock price ultimately
reflects a
reasonable multiple of these very underlying earnings. If a stock price
falls too low relative to corporate profits, investors step in to buy shares
cheap bidding their prices higher. And the opposite is true if a stock grows
too expensive relative to earnings.

In the gold-mining industry, the price of gold is the dominant driver
of corporate profits by far. Mining costs are largely determined by the particular
deposit being mined, and are largely fixed when any mine is designed and constructed.
So gold miners' profits are almost totally dependent on the price of gold.
The higher it happens to be, the larger their margins grow since their costs
generally don't change much.

This dynamic is what has long made gold stocks attractive to investors. When
the gold price rallies, the profits of gold miners rocket higher much faster.
If a miner can produce gold for $900 an ounce, and sell it for $1200, its profits
are $300. But if gold merely climbs 25% higher to $1500, that same miner's
profits double to $600. This inherent profits leverage to gold makes
the gold stocks really amplify gold's moves.

But as in all stock-market sectors, this key fundamental relationship between
earnings and stock prices can be temporarily derailed by sentiment extremes.
Sometimes investors get greedy, and bid gold-stock prices up far higher than
their gold-driven profits could ever support. And other times they get scared,
selling so aggressively that prices fall far below their earnings-supported
levels. Great fear has plagued gold stocks.

This has hammered this sector to truly fundamentally-absurd
levels relative to the metal that drives its profits. The leading gold-stock
index is the NYSE Arca Gold BUGS Index, widely known by its symbol HUI. Back
in early November, this gold-stock-sector measuring rod was crushed down
to 146.8. The last time this index had been lower was a whopping 11.3
years earlier all the way back in July 2003.

The problem was these recent extreme lows were spawned by overwhelming fear,
not underlying profits fundamentals. In early November 2014, the gold price
fell just under $1150. But the last time the HUI had been so low over a decade
earlier, gold was trading near $350. Does it make any sense at all for gold
stocks to be trading at the same levels despite gold being 3.3x higher? No,
it's a crazy fear anomaly.

Gold stocks are priced as if gold was just 30% of its prevailing levels
today. Imagine this same kind of vast fundamental disconnect in another industry.
What if Apple's stock was trading at levels reflecting it selling just 30%
of the iPhones it's actually selling? Investors would rush to buy it, knowing
full well that extreme sentiment-driven fundamental anomalies never last for
long. Why should gold stocks be any different?

And make no mistake, investors will return. Between the birth of gold
stocks' secular bull in November 2000 and its peak in September 2011, the HUI
skyrocketed a mind-boggling 1664% higher! This nicely leveraged gold's own
603% gain over that span, and trounced the benchmark S&P 500's 14% loss.
The investors who were willing to buy gold stocks cheap back in the early 2000s
earned vast fortunes over a decade.

But sentiment started to turn in 2012, when the HUI slipped 11% despite gold
gaining 7%. And 2013 was the year of QE3, the Fed's wildly-unprecedented debt-monetizing
money printing that spawned an incredible stock-market
levitation. As the US stock markets inflated dramatically on nothing but
Fed hot air, alternative investments like gold were wholesale abandoned. Why
buy gold when stocks are soaring?

So in 2013 the HUI plummeted 55% to gold's 28% loss. Truly gold stocks should
have bottomed after such an extreme down year, as fear in this sector was off
the charts. And indeed they spent most of 2014 regaining
ground, but that great progress collapsed in recent months. Now year-to-date,
the HUI has dropped 20% to a mere 2% gold loss, reflecting the ongoing extreme
and irrational fear in this sector.

But gold stocks can't fall relative to gold forever, they can't be forced
into a situation where their various earnings multiples are merely a fraction
of the broader stock markets' indefinitely. Like everything else in the markets,
the relationship of gold-stock prices to gold levels is forever cyclical.
Greedy uplegs push gold stocks well above reasonable levels relative to gold,
then fearful corrections hammer them back below.

As this chart reveals, that relationship has swung the latter direction for
far too long. Which means a major reversal is imminent, certainly in
2015. Plotted here is the popular GDX Gold Miners ETF as a gold-stock metric,
in addition to the relationship between this and the GLD SPDR Gold Shares gold
ETF. The GDX/GLD Ratio shows where gold stocks are trading relative to gold,
which ultimately drives their profits.

Just this week, the GDX/GLD Ratio slumped to 0.149x. In other words, GDX's
share price was trading at just over 1/7th of GLD's. Incredibly this is the
lowest level ever witnessed, in these terms gold stocks have never been
cheaper relative to gold! GDX was born in May 2006, the last time gold
stocks were in favor. And even during 2008's once-in-a-century stock panic,
the GGR merely plunged to 0.227x at worst.

And that stock panic was almost certainly the greatest fear event we'll witness
in our lifetimes. The VIX fear gauge skyrocketed up to an astounding 81 in
November 2008, epically high. So it's mind-boggling that gold stocks are now
much cheaper relative to gold than they were even in that incredible fear super-storm.
That is supremely irrational and reflects the extreme fear-driven fundamental
anomaly dogging this sector.

In absolute terms, GDX's price fell to $16.59 in early November 2014. That
was its worst levels in 6.0 years, since a single day near the stock
panic's climax in October 2008 where GDX briefly fell to $16.37 before bouncing
sharply higher. So gold stocks have never been or almost never been more out
of favor than they are today when measured in both relative-to-gold and absolute
terms. It's just a crazy anomaly.

And this devastating sentiment trend has been in place since late 2007, as
evidenced by the GGR's secular-resistance line shown above. When this key fundamental
gold-stock ratio is falling, gold stocks are losing ground relative to gold.
Gold, as represented by GLD, has been outperforming gold stocks on balance
ever since. But gold stocks' relationship to gold is forever cyclical, making
this an extreme aberration.

In gold-stock uplegs, the equities outperform the metal so the GGR rises.
In gold-stock corrections, the metal doesn't fall as fast as the stocks so
the GGR falls. So if you think of the gold price as a straight line, gold-stock
price levels oscillate around that like a sine wave. Outperformance is always
followed by underperformance which soon yields to outperformance again. And
this cycle continues into perpetuity.

Typically this sentiment-driven oscillation sees gold-stock uplegs that run
for up to several years on the outside, followed by gold-stock corrections
that typically take 6 months or so. But incredibly today, the gold stocks have
been underperforming gold on balance for an astounding 7.1 years! This
makes zero sense fundamentally given prevailing gold prices of recent years,
so it is solely the product of extreme sentiment.

The main thing that pushed this gold-stock underperformance into such extreme
bear territory is the Fed's hyper-manipulative QE3 campaign. Note above that gold
stocks had bottomed and were climbing sharply in 2012 before the Fed hatched
its QE3 scheme. But as QE3 convinced stock traders the Fed would arrest any
material stock-market selloff, they abandoned alternative investments including
gold stocks.

As the general stock markets soared with the Fed's implied backstop in QE3,
gold and its miners' stocks were crushed. The worst of the selling came in
2013's second quarter, when gold plummeted 22.8% in its worst quarterly loss in
93 years! GDX collapsed 35.3% in that span, the most extreme selling seen
in gold stocks since late 2008's panic. And they'd started recovering nicely
this year, until recent months.

With the Fed's QE3 manipulations enticing or forcing most investors
into the dangerously-overvalued US
stock markets, investors have largely been absent from the gold market. This
has given American futures speculators carte blanche to run amuck. So in the
last couple years the gold price has been dominated by their leveraged trades,
particularly short-side bets. And recent months saw extreme
gold-futures shorting.

As gold temporarily broke below its $1200 support zone in late October and
early November, many remaining gold-stock investors capitulated. After years
of misery, they finally gave up on this seemingly cursed sector. But that in
itself is a major bottoming indicator, a major downside washout after years
of falling prices. And that is one of the key components setting us up for
a massive gold-stock upleg coming in 2015.

Why 2015? The sole reason gold suffered such an extreme down year in 2013
was the Fed's stock-market-levitating QE3 campaign. Every time the stock markets
started to sell off, the Fed either stepped in to jawbone them back higher
or traders assumed it would. But after being born in September 2012 and ramping
up to full steam in December 2012, the Fed finally killed off QE3's new bond
buying in October 2014.

With QE3 gone, and any QE4 a
political impossibility for the Fed with the new Republican Congress,
the stock markets just lost their driver that pushed them to such wildly
overextended and overvalued levels. So sooner or later here, a major stock-market
selloff is going to erupt and start cascading. And the Fed won't be able
to act to slow it down. It lost its window to monetize more debt, and interest
rates are already at zero.

As this stock-market selloff persists, likely gradually growing into a
new cyclical bear, the Fed-devastated alternative investments led by
gold will return to favor. And as gold inevitably rebounds, the radically-undervalued
gold stocks are going to soar. The Fed's stock-market levitation killed gold
in 2013, and the end of the Fed's stock-market levitation in 2015 will restore
gold. Gold stocks will simply amplify gold's ride higher.

And their upside potential is truly epic. Once again, this week the GGR slumped
to an all-time low of 0.149x. In the initial two-and-a-half years after the
stock panic, this gold-stock valuation metric averaged a far-higher 0.419x.
Merely to return to those normal-year levels, GDX (and the HUI) would have
to nearly triple with a massive 182% gain! Can you imagine any other
stock-market sector with such potential in 2015?

And the last time gold stocks were actually in favor with investors was before
the stock panic. The pre-panic average GGR in the first eight calendar quarters
of GDX's existence was 0.591x. If gold stocks actually returned to favor again,
which is certainly possible in a weak general-stock environment, they would at
least quadruple from current levels. And I say at least for a couple reasons,
gold and smaller gold stocks.

When the lofty US stock markets inevitably roll over and enter their overdue
down cycle, gold is going to catch a major bid. Once again investors will start
remembering the millennia-old wisdom of prudent portfolio diversification,
so capital will flood back into the yellow metal. And given the extreme degree
of underinvestment in the gold asset class today, this re-diversification is
going to launch gold much higher.

As of the end of November, the 500 elite stocks of the S&P 500 had a collective
market capitalization of $19,217b. Meanwhile GLD, the vehicle of choice for
stock investors to gain gold exposure, was valued at just $28b. For centuries
at least, the best investment advisors have recommended everyone have at least
5% of their portfolio in gold. But for our purposes today, let's assume that
can rise to merely 1%.

Today stock investors have just 0.15% of their capital in GLD as compared
to their S&P 500 allocation. To get to 1%, which is still quite low historically,
the amount of capital in gold at today's prices would have to soar 6.9x! That
much buying alone, not even counting traditional physical-gold investment,
would certainly catapult the beaten-down gold price far higher. And that would
flow through to the GGR.

As gold rallies, so will GLD which tracks the gold price. That means any given
GGR will necessitate much-higher gold-stock levels. For example, back in 2012
before the Fed's QE3 manipulations goosed the stock markets and decimated alternative
investments, gold averaged just under $1675. That's an amazing 41% above today's
levels! If gold just returned to pre-QE3 levels, gold-stock prices would soar
accordingly.

Because of GLD's annual 0.4% management fee over its decade since inception,
it now trades at about 96.1% of the gold price. So let's call $1675 gold $161
in GLD-share-price terms. At those levels and the initial post-panic-average
GGR of 0.419x, GDX would have to rocket over $67. That's a 275% upleg from
current depressed gold-stock prices! Again, what other sector can quadruple from
stock-market highs?

But gold-stock investors' gains are likely to be even larger if they choose
the right stocks. GDX and the HUI are dominated by the major gold miners, which
have less upside potential than smaller gold miners. The large elites are so
massive that it will take far more capital to overcome their inertia and drive
their stock prices higher. The greatest performers in the next gold-stock upleg
will be the best of the smaller miners.

GDX's biggest holdings are mega-miners Goldcorp, Barrick Gold, and Newmont
Mining. They have market capitalizations around $14.8b, $12.7b, and $9.5b today.
It takes a lot of investor buying to push larger stocks higher. But the best
of the smaller gold miners and explorers have market caps ranging from $0.1b
to $2.5b, far smaller than the majors. So it will take far lower capital inflows
to blast them higher.

A carefully-handpicked portfolio of the best of the smaller gold miners and
explorers will trounce the coming gains in GDX and the HUI. The sheer profits
leverage to gold many of these smaller miners have is breathtaking. And if
they've survived this terrible and fearsome winnowing of the past couple years,
they have cut costs to the bone. So their profits are going to explode higher as
the gold price inevitably normalizes.

The only hard part is picking the best, the fundamental elite, of the smaller
gold miners and explorers. And that's an area we've long specialized in at
Zeal. We've been deeply researching gold and silver stocks for well over a
decade, and our knowledge in this area is unparalleled. Every few months, we
dig deep into a precious-metals-stock sub-sector and whittle that universe
down to our dozen fundamental favorites.

They are profiled in depth in fascinating fundamental
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The bottom line is gold stocks are set to shine again in 2015. They've fallen
relative to gold for far too long, driven by the impact of the Fed's brazen
stock-market manipulations on gold. But with QE3 done and any QE4 now politically
impossible, the stock markets' implied backstop has vanished. Without the Fed's
support, the next major selloff is going to be far larger. That will start
bringing investors back to gold.

As gold rebounds and normalizes in this post-QE3 era, the wildly-undervalued
gold stocks are going to just soar. Despite gold being way up near $1150 at
the recent gold-stock lows, this sector was merely trading as if it was $350!
This insane fundamentally-absurd disconnect can't last for long, as all stocks
are ultimately bid to levels reflecting their underlying earnings. So gold
stocks are heading far higher soon.

If you have questions I would be more than happy to address
them through my private consulting business. Please visit www.zealllc.com/financial.htm for
more information.

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and really appreciate your feedback!

Mr. Hamilton, a private investor and contrarian analyst,
publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis
of markets, geopolitics, economics, finance, and investing delivered from an
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